DANIEL W. HALPIN, PURDUE UNIVERSITY BOLIVAR A. SENIOR, COLORADO STATE UNIVERSITY JOHN WILEY & SONS, INC.

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1 FINANCIAL MANAGEMENT AND ACCOUNTING FUNDAMENTALS FOR CONSTRUCTION DANIEL W. HALPIN, PURDUE UNIVERSITY BOLIVAR A. SENIOR, COLORADO STATE UNIVERSITY JOHN WILEY & SONS, INC.

2 This book is printed on acid-free paper. Copyright C 2009 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) , fax (978) , or on the web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) , fax (201) , or online at Limit of Liability/Disclaimer of Warranty: While the publisher and the author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor the author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information about our other products and services, please contact our Customer Care Department within the United States at (800) , outside the United States at (317) or fax (317) Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at Library of Congress Cataloging-in-Publication Data: Halpin, Daniel W. Financial management and accounting fundamentals for construction / Daniel W. Halpin and Bolivar A. Senior. p. cm. Includes index. ISBN (cloth) 1. Building Estimates. 2. Construction industry Accounting. 3. Building Cost control. 4. Construction industry Finance. I. Senior, Bolivar A. II. Title. TH435.H dc Printed in the United States of America

3 CONTENTS PREFACE ix 1 INTRODUCTION 1 The Big Paradox / 1 What Is Financial Management? / 2 First Stop: Financial Accounting / 2 Why Construction Accounting Is Different from Accounting in Other Business Sectors / 4 Who Is at Risk? / 5 Projects: The Output of the Construction Process / 6 Project-Level Controls / 7 Time Value of Money / 8 Entrepreneurial Issues / 8 Review Questions and Exercises / 9 2 UNDERSTANDING FINANCIAL STATEMENTS 11 Introduction / 11 Why Should You Care about Accounting? / 12 Generally Accepted Accounting Principles / 12 Cash and Accrual Bases: Two Ways to Look at Accounting / 13 Cash Basis of Accounting / 14 Accrual Basis of Accounting / 15 iii

4 iv CONTENTS Accounts / 16 Account Hierarchy / 16 Financial Reports / 17 Bookkeeping / 19 The Balance Sheet / 20 Balance Sheet Layout / 21 Balance Sheet Account Categories in Detail / 21 The Fundamental Accounting Equation / 22 Asset Values / 23 The Fundamental Equation and Owners Risk / 24 Balance Sheet for Fudd Associates, Inc. / 24 Key Accounts / 26 The Income Statement / 29 Components of an Income Statement More Details / 32 The Statement of Cash Flows / 35 Contract Backlog / 37 Public Corporations / 38 Review Questions and Exercises / 39 3 ANALYZING COMPANY FINANCIAL DATA 43 Introduction / 43 Vertical and Horizontal Analyses / 44 Vertical Analysis: Financial Ratios / 44 Liquidity Indicators: Can This Company Get Cash in a Hurry? / 45 Current Ratio / 45 Quick Ratio / 46 Working Capital / 47 Profitability Indicators: Is This Company Making Enough Profit? / 48 Return on Equity / 48 Return on Revenue / 50 Return on Assets / 51 Earnings Per Share / 51 Efficiency Indicators: How Long Does It Take a Company to Turn over Its Money? / 52 Average Age of Inventory / 53 Average Age of Accounts Receivable (Collection Period) / 55 Average Age of Accounts Payable / 56 Other Average Ages / 57 Operating Cycle / 57

5 CONTENTS v Turnover Ratios / 58 Revenue to Assets Turnover / 58 Capital Structure Indicators: How Committed Are the Owners? / 59 Debt to Equity / 60 Assets to Equity (Leverage) / 60 Other Indicators / 60 Horizontal Analysis: Tracking Financial Trends / 62 Time Series Graphs / 62 Index-Number Trend Series / 63 Conclusion / 63 Review Questions and Exercises / 64 4 ACCOUNTING BASICS 71 Introduction / 71 Transaction Processing / 71 Journalizing the Transaction / 73 A Transaction to Enter Initializing Capital / 74 A Vendor Billing Transaction / 74 A Billing to the Client / 76 Posting Entries to the Ledger / 78 Relationship of Work-in-Progress and Revenue/Expense Accounts / 80 Closing the Accounting Cycle / 82 Recognition of Income / 83 Percentage-of-Completion Method of Income Recognition / 83 Completed-Contract Method of Income Recognition / 85 Transactions during a Period / 86 Posting to the General Ledger during the Accounting Period / 88 Closing Actions at the End of the Period / 91 Review Questions and Exercises / 93 5 PROJECT-LEVEL COST CONTROL 97 Objectives of Project-Level Cost Control in Construction / 97 Unique Aspects of Construction Cost Control / 98 Types of Costs / 99 The Construction Estimate / 99 Cost Control System / 101 Building a Cost Control System / 101 Cost Accounts / 103 Cost Account Structure / 104

6 vi CONTENTS Project Cost Code Structure / 106 Cost Accounts for Integrated Project Management / 110 Earned Value Analysis / 113 Labor Data Cost Collection / 122 Review Questions and Exercises / FORECASTING FINANCIAL NEEDS 129 Importance of Cash Management / 129 Understanding Cash Flow / 129 Retainage / 131 Project Cost, Value, and Cash Profiles / 131 Cash Flow Calculation A Simple Example / 133 Peak Financial Requirements / 136 Getting Help from the Owner / 137 Optimizing Cash Flow / 138 Project Cash Flow Estimates / 141 Using Software for Cash Flow Computations / 144 Company-Level Cash Flow Planning / 145 Strategic Cash Flow Management: Cash Farming / 145 Project and General Overhead / 146 Fixed Overhead / 148 Considerations in Establishing Fixed Overhead / 149 Breakeven Analysis / 151 Basic Relationships Governing the Breakeven Point / 154 Review Questions and Exercises / TIME VALUE OF MONEY AND EVALUATING INVESTMENTS 161 Introduction / 161 Time Value of Money / 162 Interest / 162 Simple and Compound Interest / 163 Nominal and Effective Rate / 165 Equivalence and MARR / 166 Discount Rate / 167 Importance of Equivalence / 167 Inflation / 168 Sunk Costs / 169 Cash Flow Diagrams / 169 Annuities / 171

7 CONTENTS vii Conditions for Annuity Calculations / 173 Calculating the Future Value of a Series of Payments / 174 Summary of Equivalence Formulas / 175 Worth Analysis Techniques: An Overview / 176 Present Worth Analysis / 179 Investments with Different Life Spans / 180 Equivalent Annual Worth (EAW) / 181 Internal Rate of Return / 183 Limitations of the IRR Method / 185 An Example Involving Cost Recovery / 186 Comparison Using EAW / 188 An IRR Example Owner Financing Using Bonds / 191 Review Questions and Exercises / CONSTRUCTION LOANS AND CREDIT 199 Introduction / 199 The Construction Financing Process / 200 A Sample Developmental Project / 202 The Amount of the Loan / 204 How Is the Cap Rate Determined? / 205 Mortgage Loan Commitment / 206 Construction Loan / 206 Commercial Lenders / 208 Lines of Credit / 209 Interest Paid on Outstanding Balance / 210 Commitment Fees / 211 Compensating Balances / 211 Clean-Up Requirement / 212 Collaterals / 212 Accounts Receivable Financing / 213 Trade Credits / 213 Long Term Financing / 215 Loans with End-of-Term Balloon Payments / 216 Review Questions and Exercises / THE IMPACT OF TAXES 219 Introduction / 219 Types of Taxes / 220

8 viii CONTENTS Income Tax Systems / 221 Alternatives for Company Legal Organization / 221 Sole Proprietorships / 222 Partnerships / 222 Corporations / 222 Limited Liability Partnerships and Companies / 223 Other Options / 224 Taxation of Business / 224 Business Deductions in General / 227 Taxable Income: Individuals / 227 Itemized Deductions, Standard Deductions, and Personal Exemptions / 228 The Tax Significance of Depreciation / 229 Calculating Depreciation / 230 Straight Line Method / 231 The Production Method / 232 Depreciation Based on Current Law / 233 Marginal Tax Rates / 235 Tax Credits / 238 Tax Payroll Withholding / 239 Tax Payment Schedules / 239 Marginal, Average, and Effective Tax Rates / 239 Net Operating Losses / 240 Taxes on Dividends and Long-Term Capital Gains / 242 Alternative Minimum Tax / 242 Summary / 243 Review Questions and Exercises / 243 APPENDIX A TYPICAL CHART OF ACCOUNTS 247 APPENDIX B FURTHER ILLUSTRATIONS OF TRANSACTIONS 251 APPENDIX C COMPOUND INTEREST TABLES 275 REFERENCES 301 INDEX 305

9 PREFACE It has been noted that the construction industry is the engine that drives the national economy. Estimates of the of the total annual construction volume in the United States range as high as a trillion (1,000,000,000,000) dollars annually. Recent problems generated by a downturn in the real estate and construction markets have triggered a period of financial turmoil and government intervention to shore up economies worldwide. Financial management of construction revenues and cash flow in this sector obviously has a major role to play in world markets and economic stability in general. Financial management and the measurement of financial activity in the construction industry is unique, since most revenues are generated in the context of projects that are designed and constructed. That is, the basic production unit of this gigantic industry is the project. This is in contrast to other industries, which produce units such as automobiles and electrical appliances or services to individuals such as medical care or foodservice. The number of projects that even a large contractor has at any given point is substantially smaller than the number of cars, refrigerators, or patients that businesses in the other industries produce or service. Moreover, the time frame involved in realizing a construction project ranges from a few weeks up to several years, compared to the few days, hours, or minutes typical of production or service activity in other industries. As will be discussed in this text, the small number of unique projects and the extended period of time required for the completion of each one place special requirements on the accounting and financial management systems typical of the construction industry. This book takes advantage of experience gained from using a previous text by one of the coauthors, both in the classroom and as a professional reference. This original book by Halpin, entitled Financial and Cost Concepts for ix

10 x PREFACE Construction Management, was also published by John Wiley and Sons, Inc. (Wiley, 1985). The stated objective of that text was to present both company and project levels of revenue and expense management in an introductory but integrated format.... The Halpin text emphasized how financial activity at the project site is collected and reported to the company level to provide data for financial reporting, control, and management purposes. The present book draws upon the strengths of this original text by reflecting present-day practice and adding information regarding business taxation, project control, engineering economy, and financial forecasting. The audience for the present book is primarily practitioners and students who may have a strong technology and engineering background, but relatively limited training in the areas of financial management and accounting. It is hoped that this book will help these individuals to become more aware of the way in which fiscal topics and the ebb and flow of revenues and expenses impact the generation of income and profit. In addition, for those individuals who are familiar with conventional accounting methods in manufacturing and service industries, this book will, hopefully, provide insights into how the project format of construction changes the way in which financial management is exercised in this large and specialized industry. Chapters 1 to 4 provide an introduction to company-level financial management and accounting topics such as financial reporting, analysis of financial data, and the rudiments of the accounting procedures required to generate company Balance Sheets, Income Statements, and summary documents. Chapter 5 addresses the importance of cost control systems and the establishment of cost accounts at the project level. Chapter 6 looks at the issues involved in forecasting cash flow and controlling overhead as well as concepts such as breakeven analysis. Chapters 7 and 8 deal with the way in which borrowing, interest, and the time value of money influence financial decision making. Chapter 9 presents an introductory treatment of taxation and its impact on company operations and fiscal management. The appendices provide support material covering the structure of a typical Chart of Accounts, the flow of various types of transactions through a construction accounting system, and tables required for mathematical analysis of transactions in which interest and time value of money must be considered. Each chapter has been designed to be as self-contained as possible. Many college construction programs resort to the use of multiple generic courses in accounting, engineering economy, and other similar topics to address the subject matter covered here. It is hoped that the relative autonomy of each chapter provides teaching flexibility and adequate subject coverage within the context of a single-course format. Review questions and exercises are included at the end of each chapter. They emphasize open ended thinking and reasoning rather than mechanical responses. The most common keywords found, even in numerical questions, are why, explain,and discuss. It is hoped this approach will promote freeform

11 PREFACE xi responses and a better understanding of the chapter s content. The construction-specific nature of the book is designed to provide a practiceoriented context to support better understanding of the generic (e.g., accounting, etc.) subject matter. ACKNOWLEDGMENTS Many people have made important contributions to this book. Material covered in this text has been taught by the authors to classes at Colorado State University, Georgia Institute of Technology, Purdue University, and the University of Maryland, College Park, over the past 20 years. Feedback from students has been incorporated into this to reworking of the classroom material. The authors would also like to thank colleagues who have used this text and provided feedback on improvements and modifications. In particular, the authors would like to recognize E. Paul Hitter, Jr. of Messer Construction Co. in Cincinnati, Ohio, for reviewing some of the chapters and providing comments from a practice-oriented viewpoint. Finally, we would like to recognize the support and patience of our wives, Maria and Ana, during the preparation this text. Daniel W. Halpin, Crestview Hills, Kentucky Bolivar A. Senior, Ft. Collins, Colorado

@ WILEY FINANCIAL MANAGEMENT AND ACCOUNTING FUNDAMENTALS FOR CONSTRUCTION

@ WILEY FINANCIAL MANAGEMENT AND ACCOUNTING FUNDAMENTALS FOR CONSTRUCTION FINANCIAL MANAGEMENT AND ACCOUNTING FUNDAMENTALS FOR CONSTRUCTION DANIEL W. HALPIN, PURDUE UNIVERSITY BOLIVAR A. SENIOR, COLORADO STATE UNIVERSITY @ WILEY JOHN WILEY & SONS, INe. CONTENTS PREFACE 1 INTRODUCTION